Inflation and central bank actions

In general, central banks increase base rates when the inflation rates increase beyond central banks' targets and decrease base rates when the inflation rates fall below the targets. However, in the complicated real world, inflation rates in different countries are different and countries are trading with each other, it is too complicated for central banks to know whether it is absolutely right to increase base rates or not. Currently, the US inflation rate is approaching the Fed's target; however, though the Fed has shown its plans of rate hikes in multiple occasions, it has not made any actual rate hike move yet. Meanwhile, the inflation rates in other countries such as Germany are slowing down below the targets. However, the central banks in these countries (particularly the ECB) have not lowered their rates, instead, some announce they may reverse their expansionary monetary policies.

Under such circumstance, central banks do not follow their own guidance. When they do not follow their guidance, the financial market is likely to react to the central banks only when they make actual policies; otherwise, the announcements from central banks only create shocks in the financial market. In addition, central banks tend to lag behind the economy that they do not react to the market expectation but the actual market performance. This creates a problem that the market does not perform in the way central banks want but central banks may react to the market in the way that the market wants or the financial institutions want.

How much do we need a membership?

Last night, Amazon announced its first quarter financial report and showed very strong perfoance, especially its Prime program boosted it's revenue. We join different kinds of memberships in the hope of getting discounts when shopping and getting more convenient access it better services, and the sellers use our expectations to sell their memberships to boost their revenues and profits.

The sellers have to make their memberships attractive enough to allow a large amount of their consumers to be willing to pay for memberships, meanwhile the memberships need to be profitable enough. Many memberships make profits based on consumers' overestimation of their commitment. The most normal example is the gym membership. Many people including myself but gym memberships and only go to gym several times in a year. Such behaviour is caused by our overestimation of our commitment to gym and we believe we are going to increase our frequencies of going to gym after we buy gym memberships; however, after we buy the gym memberships, the costs of memberships become a sunk cost that no matter how we behave in the future, this cost will not change at all, so our behaviour is independent of owning a membership after we actually buy the membership.

Therefore, the most rational way to make the decision of whether we need a membership or not is to make calculation about our consuming habit before buying a membership (without a membership), since after buying a membership, our behaviour will not change significantly. However, the problem in the reality is that we do not try or experiment enough before we buy a membetship that we usually buy a gym membership after we attend only one of its taste session. Of course, the sellers do no offer enogh taste sessions and do not have the willingness to offer sufficiently many taste sessions as they want consumers to overestimate their commitment, and this is the way of how they make more profits.

Who is going to be benefited from increasing house prices?

When a country’s housing prices increase dramatically, people may worry about a widening wealth gap due to this change. However, this depends on the structure of the overall society. Different social classes have different asset structures. Based on people’s different asset structures, those whose real estates are their greatest proportions of assets will be benefitted the most and those who do not have many real estates will be benefitted the least.

In general, the poorest people will always be isolated from the benefits brought by any type of asset appreciation, because they do not hold sufficient assets to take advantage of asset appreciation and some of them may be in debt. Then we need to distinguish the asset structure differences between the middle classes and the wealthy classes who are considered to control the 90% of the overall wealth in the society. The traditional wealthy classes, of course, hold lots of real estates; however, the rising stars from the technology sector hold significantly more equities than real estates in terms of their asset holding. For example, Bill Gates (Microsoft founder), Jeff Bezos (Amazon CEO), Mark Zuckerberg (Facebook co-founder) are well-known wealthiest men in the world, and their wealth is built by the values of the shares they hold. Jeff Bezos surpassed Bill Gates to become the world riches man when Amazon share price rose dramatically at an incredible rate at the time in 2017. Under such circumstance, the housing price increase does not affect these wealthy people’s wealth significantly. However, many middle-class people have a relatively large proportion of real estates in their asset holding. Of course, there are differences between middle-class individuals. Wealthier people tend to have more diversified asset holdings, which mean they tend to hold smaller proportions of real estates in their asset holdings.

Based on a rough and general picture of the asset structures, increasing house prices actually can narrow the wealth gap within the society, especially the gap between the middle class and the wealthy class. However, the poorest people are still left behind and become even more isolated as their distance from becoming middle class is widened.

What is expansion strategy like?

Cost complementarity measures how different product lines affect each other in terms of production; meanwhile, on the demand side, the elasticities describe the situation of the demand side in the market covering multiple products. For any company, when making its expansion action, it tends to expand its potential production capacity and maximize its profits over a longer time period.

The guidance from the production side and the guidance from the demand side contradict each other in some way. Based on the production side, a company should create new production line that has positive cost complementarity with its current production lines, so it could have lower costs for its expansion. The concept of studying from doing suggests such expansion is more likely to be within the company’s original sector and the new products produced under such expansion policy are likely to be the substitutes (including updates) for its original products. Such expansion may be effective in some certain sector; however, the company then bounds itself with the sector, while expansion across sectors may lower the company’s risk. Also based on the demand side, the company does not expand its company by producing its products’ own substitutes, as this would not boost the sales significantly. When the company tends to expand to other sector, the cost complementarity is likely to be negative.

To conclude, when companies choose their expansion strategies, the strategies that may lower the market risk are likely to worsen productivity and efficiency, and the strategies that may improve productivity and efficiency are likely to increase the market risk,

What makes the US Treasury Bill yield so high?

The US 10-year government bond has risen to a historically high point above 3%, this increase is fulfilled by the investors’ expectations about the possible rate hikes by the US Federal Reserve. When the US Federal Reserve decides to increase its rates, bond yields including corporate bond yields as well as the US Treasury Bill yield will increase in general. The rise of bond yield indicates the fall in its price as the lenders give out more interests with the same amounts of loans.

The sharp rise in the stock market last year partially contributed to the high Treasury Bill yield, as when the stock market is so attractive, in order to make investors invest in Treasury Bills, the yield has to be high enough to make Treasury Bills attractive. Moreover, the political tensions have weakened, especially when North Korea shows its willingness to be back to the negotiation table with other countries (by the time, the Far East was believed to the place where it was the most likely to have a war).

When there is no intervention from the central bank, the stock prices and the bond prices move in the opposite directions. However, when the central bank intervenes and raises the base rates, the stock prices will fall, and the bond yields will soar (in other words, the bond prices will fall), so the stock prices and the bond prices move in the same direction. After the central bank intervention, the stock prices and the bond prices will then move apart.

What does a US sanction on Russia cause?

It is unclear about if there will be a further US sanction on Russia and if there is, what the sanction will be. It is almost certain that the US government will not be as harsh as it may have sounded as it is possible that the US government may not place a further sanction on Russia. The public wants to know what a US sanction on Russia means to ordinary people. In general, a sanction will not affect most of the ordinary people unless if they live in Russia or do businesses with Russians. However, such sanction could influence the global financial market, which might affect many people’s investment in assets and their pension funds.

Russia is a country that exports natural resources to the world. After the US government softens on the sanction issue, the price for aluminium drops significantly, this is the same for other types of natural resources including crude oil as well. This will push up the stock prices of the companies which demand these natural resources as raw materials for production but drag down the prices for companies that mine these natural resources or provide alternative solutions (such as solar companies). In addition, sanctions on Russia, this kind of powerful nations, would raise the world concern about the tensions between superpowers. This could increase the price of the US Treasury Bills. The concerns surrounding the trade war between China and the US have raised the worries of the investors worldwide, this increases the demand for secured assets such like the US government bonds, so the bond price will increase and the yield will fall; the stock market performance is inversely correlated with the US bond price. When the tension between the US and Russia is relieved, this will lower the bond price and increase the bond yield. The US bond yield has hit nearly 4-year high, this shows the financial market has not been very cautious about the consequence of the trade war between the US and China.

To conclude, if the US does not place a sanction on Russia, in the short term, it definitely is good news for the world financial market in general, as it relieves the tension between the US and Russia and lowers the probability of conflicts between these two powerful countries in the short term. However, given the ongoing trade war between China and the US and the yield hits 4-year high, I think it is possible that the US bond is undervalued.

Time constrained investors

Some investors do not have a mean-variance preference or goal when making their investment, instead they want to maximize their capital returns over a certain time period. For this type of investors, their attitudes would be very likely to be different from what we consider as rational investors or economic man.

This type of investors are often seen in the real world. Those who work for financial institutions including funds are often this type of investors, since their performances are evaluated every quarter by their committees and sponsors (investors). Then this will explain the change in those investors’ risk preferences when they experience different capital returns. In general, investors are risk seeking when they suffer losses, and risk averse when they experience capital gains. When they make losses, to meet their goals, they have to take more risky and aggressive actions to meet the goals before the evaluation day. However, if they make good progress at the beginning, they want to keep the gains, so they will be more conservative (in other words, more risk averse).

What is the effect of the existence of such investors then? Such investors would behave like noise traders, though they may have very good knowledge about the financial market and the assets they invest in. However, because we know the financial market does not perfectly reflect its fundamentals, the investors with this type will trade based on the market momentum rather than the fundamentals. This will further deviate the financial market from its fundamental value.

Since we know institutional investors including fund managers face performance evaluation pressure from their sponsers, they are like to be this type of investors. Because the institutional investors are influential, the financial market would not be at its fundamental level and would be deviated by the market momentum created by retail investors as well as institutional investors.